Gold: the ultimate inflation hedge

Should investors put their trust in the world's oldest inflation hedge?

Is gold the ultimate hedge against inflation? Many investors clearly think so and with inflation now running at twice the Government's target it is not surprising that gold hasn't lost its lustre.

Recent research from the World Gold Council shows how gold has held its value over the long term when compared with other commodities. The relative price of gold and oil has remained almost constant over the past 50 years. So although the price of both (in either pounds or dollars) has risen during this period, if you were buying a barrel of oil with bullion you would hand over roughly the same weight of gold as you would have done in 1950.

More startling is that gold has retained this purchasing power over even longer periods. It is thought that an ounce of gold bought 350 loaves in the time of Nebuchadnezzar, the king of Babylon who died in 562BC. An ounce of gold still buys roughly 350 ordinary sliced loaves today, showing that over 2,500 years gold has proved a very effective hedge against inflation, at least when it comes to everyday essentials.

Given our current economic situation, it's not hard to see why there is increasing demand for an asset that appears to offer inflation-proofed returns.

The consumer prices index (CPI), the Government's preferred measure of inflation, is now running at 4pc, while the retail price index (RPI), which takes into account housing costs and is for many people a more realistic gauge of how prices are rising, stands at 5.1pc. Both are expected to rise further this year.

With wages flat, and interest rates so low, many families are now feeling the corrosive effects of this inflation. Not only are their salaries and pensions losing their everyday purchasing power, but their savings are diminishing in value.

If inflation remains at its current rate, the value of your savings, in real terms, will have halved in little more than 15 years.

According to Moneyfacts, the financial data provider, not one savings account in Britain pays sufficient interest for savers to earn a real return once tax and inflation (as measured by the RPI) have been taken into account.

There are a handful of accounts that can beat the CPI, but most of them are Isas, into which you can deposit only a fairly limited amount of money, and even then you have to lock it away for at least three years to get this return.

So with this inflationary background, it is perhaps not surprising that demand for gold is rising. And as supply is limited (relatively small amounts are mined each year), that has helped to drive prices ever upwards.

Gold has certainly enjoyed a sparkling decade. It is traditionally priced in dollars and is still weighed by a medieval measure called the Troy ounce. One ounce (just over 30 grams) currently costs about $1,375, compared with just over $200 an ounce in 2001 – an almost sevenfold increase.

Economic uncertainty has helped drive gold prices: in 2008, at the height of the global financial crisis, the price rose by almost 44pc over the year, as the asset class has traditionally been seen as a haven amid times of stock market turbulence.

But although equities recovered, and enjoyed buoyant returns in 2010, gold prices have continued to surge ahead. British investors saw a 34.5pc return on gold last year, as inflation and European debt problems sparked new fears in the markets.

In fact, over the past 10 years gold has fallen in value in only one year – in 2004, when prices dipped by just 2pc.

But despite these positive figures many advisers urge caution.

Patrick Connolly, of the financial adviser AWD Chase de Vere, said: "There continue to be bullish statements and bold predictions about gold and the assumption that the returns seen over the past decade are now the norm. There were similar sentiments in 1999 about technology stocks, and the belief that the only way was up."

As he pointed out, there is a real danger that this could be a "gold bubble", and when prices do fall - which they will at some point - the correction could be far sharper and last longer than many people expect.

He added: "It's easy to forget that gold prices can go through prolonged downturns. During the Eighties and Nineties, the price of gold fell by 70pc."

Even if gold holds its value against other commodities, investors will lose out if its price in pounds falls. After all, when you are filling up the car, most petrol stations will not accept payment in gold bars.

Although gold is a good inflation hedge over the long term, this isn't always the case over shorter, more realistic time frames over which the typical investor is more likely to hold the asset. If you bought gold in the Eighties, for example, it hasn't proved to be the most effective hedge against inflation since then. If it had kept pace with prices, it would now be worth about $2,600 an ounce.

Martin Bamford, a chartered financial planner with Informed Choice, said: "Investors are understandably concerned about inflation at present. But there is a real risk that those now buying gold are doing so at the top of the market and will end up making losses when prices fall."

He added that investors should remember that gold does not produce any income, in terms of either interest or dividends, so returns are based solely on capital growth. He said: "It can also be difficult to access as an asset class: many people end up buying funds that are largely invested in mining stocks, which don't always reflect gold prices accurately."

Other options include buying gold bullion or coins, or investing in an exchange-traded fund (ETF), which basically follows the price of gold. This week Standard Life teamed up with GoldMoney, the metals dealer, to enable investors to buy gold bullion through their Sipp (self-invested personal pension).

Mr Bamford said: "I'm all for choice, and such innovation helps investors diversify. But I'd be wary about getting into gold at present. The price may still rise further, but the gains are unlikely to be so significant. When prices fall, it is those who got in near the end who will suffer the biggest losses."

He added that there were also investment costs to consider, such as the cost of storing, trading and insuring bullion, or dealing charges on ETFs. "A diversified investment portfolio, containing shares, property and bonds, may be a better way to protect against inflation.

And about a third of the stocks in the FTSE 100 are commodity-related stocks, whose performance will be correlated to gold prices. There is a danger that people are buying now when prices are overheated and becoming overexposed to one asset class," Mr Bamford said.